Question

(Real options and capital budgeting​) You have come up with a great idea for a​ Tex-Mex-Thai fusion restaurant. After doing a financial analysis of this​ venture, you estimate that the initial outlay will be $6 million. You also estimate that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $760,000 per year forever​ (a perpetuity), while there is a 50 percent chance of it producing a cash flow of only $200,000 per year forever​ (a perpetuity) if it​isn't received well.

a. What is the NPV of the restaurant if the required rate of return you use to discount the project cash flows is 10​percent?

b. What are the real options that this analysis may be​ignoring?

c. Explain why the project may be worthwhile even though you have just estimated that its NPV is​ negative?

Answer 1

a]

Expected NPV = (probability of success * NPV if success) + (probability of not success * NPV if not success).

NPV in each case = present value of perpetual cash flows - initial outlay.

present value of perpetual cash flows = annual cash flow / discount rate.

Expected NPV = [(($760,000 / 10%) - $6,000,000) * 50%] + [(($200,000 / 10%) - $6,000,000) * 50%] = -$1,200,000.

b]

The real option is that the project can be abandoned after 1 year if it is not received well.

c]

The project may be worthwhile because if the value of the real option is considered, the expected NPV may be positive.